Article about the derivatives market

[Narz]

I didn't even know what the derivatives market was ten minutes ago.

To people who did, what do you think of this article, should we be legitimately worried?

Thanks,
Narz

P.S. : I know it's from a website of a guy selling something, however I'm still interested in hearing responses to his argument.

http://www.mcalvany.com/TheDerivativesMarket.asp

The Derivative’s Market –

America’s Financial Time Bomb


“The world has avoided a major financial crisis for more than seven years. This is due more to luck than design. With oil prices surging, central banks leaning against the upside of the liquidity cycle, and global imbalances mounting, that luck may now be running out.” – Stephen Roach, Chief Economist for Morgan Stanley, www.morganstanley.com (04/24/2006)

“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.” – Warren Buffett, annual report for Berkshire Hathaway (03/2003)

“The over growing scale of bank mergers raises challenging policy questions, including banking concentration at the national level and systemic risk concerns…. When banking activities are concentrated in a very few large banking companies, shocks to these individual companies could have repercussions to the financial system and the real economy.” – Simon Kwan, San Francisco Federal Reserve Bank in the Bank’s Economic letter (06/18/2004)

“Too much debt, geopolitical risk, and several bubbles have created a very unstable environment which can turn any minute more than any point in the past 20 or 30 years, there's potential for a reversal.” – Bill Gross, head of Pimco, the largest bond-trading fund in the world

“If you dig deep enough into any financial scandal, you can usually find a derivative or two to take the blame.” – Emma Clark, BBC business reporter (02/2002)

Introduction

In 1998, the hedge fund Long-Term Capital Management (LTCM) had over nearly $100 billion in assets – $4 billion of it was cash. The company used that $100 billion as collateral on $1.2 trillion in derivatives.

The company’s success was legendary. But that same year, all of it came crashing down. LTCM had a major stake in Russian bonds. When Russia defaulted on its bonds, LTCM began losing several hundreds of millions of dollars every day.

After the $4 billion was gone, the fund tried to exit all of its trades. But they weren’t the only ones. Everyone around the world who was invested in Russian bonds and anything closely associated to them was trying to exit their positions at the same time.

At this point, the Federal Reserve began to panic. With $1.2 trillion at stake, LTCM’s losses could devastate the U.S. economy. The Fed talked several of the largest banks on Wall Street into rescuing the hedge fund. But it came at a huge price. Each of the banks involved lost several hundred million dollars.

If you think the American financial system isn’t skating on thin ice, think again. LTCM’s meltdown shows that the actions of just one firm can greatly undermine the financial system we depend on. The U.S. derivatives market, which brought this hedge fund down, is at least eight times larger than our nation’s GDP.

Warren Buffet said of the LTCM fiasco:

“In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And, this affair, though it paralyzed many parts of the fixed income market for weeks, was far from a worst-case scenario.”

I. What Are Derivatives?

Derivatives are an extremely complex system of contracts. When you buy a derivative, you agree to buy or sell a security at some designated time in the future at a determined price. Technically speaking, derivatives have no value of their own. All of their value is derived – thus the name – from an underlying security. (Of course, they get their value, as do all goods and services, from the demand placed on them.)

Common derivatives are options, warrants, and futures. Many investors use them to reduce their investment risk, much like insurance. But most investors, especially institutional investors, are attracted to them because of their ability to bring incredible profits. But they also can bring staggering losses.

The derivatives market is growing faster than just about any other market in the world. In 1995, commercial banks in the U.S. had $17.5 trillion worth of derivatives on hand. By 2004, they had more than $75.5 trillion. That’s a 331% increase in just 10 years. And the market is still growing by 20-30% per year, meaning the financial markets around the world are growing more and more leveraged.

What’s worse, around 90% of the world’s derivatives are traded over-the-counter, which means there’s absolutely no regulation. Most individual investors are familiar with the 10% that are regulated, such as those traded at the Chicago Board of Trade. Because there’s no regulation on the other 90% of derivatives, there are few required reporting laws, no paper trails, and no way to know just how big the system is exactly. Most estimates put the worldwide derivatives market at $300-$400 trillion. But that’s probably just with the financial institutions. The actual number is probably much larger. Since most of the deals are private, they almost always go unreported.

However, even when regulation is created, derivatives are developed to get around the regulation. In fact, that’s part of the reason derivatives were created in the first place. As regulations on public companies and securities increased, companies began to search for ways to get around the regulations. So if new regulations come in, new derivatives will be created to get around them.

As a result, the very nature of the derivative market involves a lot of risk. But that doesn’t stop the world’s banks from participating. While banks used to invest in tangible businesses that produced solid returns, they now prefer investing in extreme risk.

II. Banks Are Becoming Severely Over Leveraged

The Office of the Comptroller of Currency (OCC) data show just how involved the banks are in the derivatives game. According their 2005 numbers, the banks had only $7.8 trillion in bank assets and $715 billion in bank equity, but they had $76.5 trillion in derivatives. In other words, the banks equity covers only 0.9% of their derivative holdings.

Most of these derivatives are held by a handful of banks. The OCC reports that only seven banks have 96% of the U.S. banking systems derivatives holdings. JP Morgan Chase Bank is the biggest player in the derivatives game. In 2004, it held $39.6 trillion in outstanding derivatives. That’s nearly four times the U.S. GDP for the same year ($11.5 trillion). After JP Morgan Chase Bank come Bank of America and Citibank. Together they held $29.3 trillion in derivatives in 2004 – nearly three times the GDP.

What happens if just one of these banks makes a mistake? It could cause a major meltdown in the banking system. And the banks are scared it could happen. In fact, the European Central Bank recently ran “stress tests” to see how well it could deal with a meltdown in its derivative holdings.

But that’s not the only bank that’s concerned. In the May 19, 2005 issue of the Financial Times, derivatives expert Gillian Tett said, “In recent days, the research departments of some investment banks have started brainstorming a striking question: could the current jitters in the credit derivatives world be the heralds of a larger market meltdown?

“For while this melodramatic scenario is not on the cards right now, recent startling price swings in some credit derivatives have taken many by surprise. Consequently, behind the scenes, some bankers and investors are quietly mulling ‘what if’ scenarios.

“‘Two weeks ago, we might have said that the chances of a market meltdown were 1 percent, but now we might put it nearer 10 percent,’ said an analyst at a large American bank. ‘The issue is being talked about.’”

In spite of fears that they may be responsible for a derivatives meltdown, the banks continue to increase their positions. And they’re doing so very aggressively.

A. The Role Bank Mergers Play in Creating Enormous Risk

We’re currently seeing a large movement in banks to merge with and acquire other banks. This merger and acquisition activity makes their derivatives positions even more worrisome. Until recently, Citigroup was the only banking organization with assets in the trillions. But M&A activity has increased that number. Bank of America merged with FleetBoston, giving it trillion-dollar assets. And JP Morgan Chase merged with Ohio-based Bank One, building its assets to over $1 trillion.

As more and more banks merge, the number of banks left to bail out a fallen competitor is greatly reduced. It also reduces the number of banks in the commercial banking system and further concentrates the derivative market. One mistake by any of those mega-banks could easy topple the entire banking system.

All it would take for the top banks to end up in hot water is one foreign bank to begin dumping U.S. bonds. That would cause long-term interest rates to jump up. It would also cause the dollar to crash. If it affects all of the banks, who is going to bail them out? The federal government will have to step in, but at what cost to the U.S. taxpayer and national economy? It would be devastating, to say the least.

But could it really happen?

B. We’ve Already Seen Several High-Profile Banking Disasters

The banks know it can happen. They saw it firsthand in 1995, when Nick Leeson single-handedly brought down the British Barings bank. He used derivatives to establish positions worth more than $60 billion. At the time, the bank had only $615 million in capital. The 233-year-old bank was forced to close its doors when its positions turned against it.

For many years, Bankers Trust, a New York investment bank, was the golden child of the banking world. It built its global business on derivatives, only to watch those same positions bring the company to its knees. It cost several major companies millions of dollars and almost had to fold.

Even JP Morgan Chase has had its share of trouble with derivatives. A January 21, 2002 article in BusinessWeek said: “(JP Morgan founded, and is by far the largest market maker in the $1 trillion market for credit derivatives, a form of loan insurance. Issuers of these derivatives lose money if insured borrowers don’t repay their loans. In the third quarter (2001), banks lost $99 million in derivatives, says the Office of the Comptroller of the Currency. Nearly all of that – $95 million – was borne by J.P. Morgan alone, says Ventana's Peabody, who expects more losses to come.”

That was just the beginning of JP Morgan’s losses. It has lost billions of dollars thanks to bad loans and derivatives. The derivatives were connected to bankrupt companies such as Enron, K-Mart, Global Crossing, Tyco, and Parmalat. With all the losses, JP Morgan is still struggling. A few analysts believed that a loss of 13% on its derivatives could fatally wound the bank. It was rumored that the Parmalat fiasco knocked up to 8% off the books.

JP Morgan Chase managed to survive all these bankruptcies. It’s stock dropped hard in 2002 and into 2003. But it’s turned up since then, as investors breathed a sigh of relief. The trouble made all of the big banks stand up and take notice, though. The next time, JP Morgan may not survive. And, as the biggest derivative player in the banking industry, its problem will cause a tsunami that few of the other major banks will survive. It could easily take down the entire U.S. economy.

C. Corporate America Sees the Danger

The banks weren’t the only ones to learn from JP Morgan’s troubles. Corporate America saw first hand how dangerous the derivatives market is. Several company bankruptcies were linked with derivatives. And the risky market has wounded many others along the way. But banks aren’t the only ones at risk. Major companies are finding out how devastating the derivatives market can be. In addition to those who lost millions with LTCM, JP Morgan and Bankers Trust, we’ve seen derivative fallouts with many other companies including WorldCom.

But the biggest one we’ve seen is Enron. Many argue that Enron actually had seen some success with derivatives, which it had. As have many others. That’s why they’re so popular. You can win with derivatives. In fact, you can win big. But few are content with winning big. It’s just too easy to get greedy. And that’s what caused Enron’s downfall.

Enron used its big profits in derivatives to hide some major losses in other parts of its business. When the accounting irregularities became public, the company lost all credibility. Its business disappeared and a lack of cash flow killed the company.

More recently, GM and Ford have run afoul of the derivatives market. While they haven’t completely imploded like Enron, their dalliances in the derivatives market have cut their value in half.

III. Even the Government Is Involved

One reason the government isn’t rushing to regulate the derivatives market is because it’s heavily involved in it. From the federal government on down to small local governments, the derivatives market is gaining in popularity. But even government isn’t immune to a derivatives fallout.

In February 2004, Gene Callahan and Greg Kaza wrote an article in Reason magazine that exposed how extensive the government’s involvement is. Their article was actually pro-derivatives. But after reading this section of their report, it’s very clear the government is in over its head with the derivatives market. They wrote: “Some of the biggest users of derivatives are government-sponsored enterprises (GSEs) such as the mortgage-lending institutions Fannie Mae, Ginnie Mae, and Freddie Mac. Doug Noland of PrudentBear.com, a site that advises investors from a bearish perspective, notes, ‘We have Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system with total holdings [of derivatives] approaching $2.2 trillion and guarantees for another $1.5 trillion of securities.’

“This year, FM Watch, a coalition of financial service and housing-related organizations dedicated to monitoring GSEs, reported: ‘One of the GSEs was able to make its RBC [risk-based capital] virtually disappear through use of derivatives and other risk-hedging devices.’ FM Watch recommends that GSEs’ ‘disclosures should be at least as complete as those provided by other publicly-traded companies and issuers.’

“The lack of transparency in governmental derivatives trading has resulted in the loss of billions of tax dollars in a string of mishaps spanning a decade. The largest municipal bankruptcy in U.S. history ($1.6 billion) occurred in Orange County, California, in December 1994, when the county treasurer used derivatives to bet that interest rates would stay low. A significant portion of the county’s funds were invested in interest-rate-sensitive two-to-five-year notes and structured notes issued by GSEs such as Fannie Mae and Freddie Mac, in addition to other derivatives.

“Through such instruments, the county’s $7.6 billion general fund was leveraged to control more than $20 billion in assets.

“The Orange County treasurer was managing a pool of money from nearly 200 California municipalities and government bodies, according to congressional testimony. The treasurer’s services were in great demand by other governmental units, because he delivered returns nearly 2 percentage points higher than a similar pool run by the state of California. Local officials increased their leverage by issuing bonds to invest in the pool.

“But in 1994 the Federal Reserve raised short-term rates, causing the treasurer’s strategy to backfire, with disastrous results for Orange County taxpayers. An effective internal controls system would have made clear what the treasurer was up to. The structured notes involved were government securities subject to government regulators, who also missed the treasurer’s misuse of leverage.

“Arkansas taxpayers also suffered after the state lost an estimated $30 million from derivatives trading despite repeated warnings from auditors. A 1997 independent audit by the private accounting firm Deloitte & Touche LLP made the following observation about the Arkansas Teachers Retirement System (ATRS): ‘Alternative investments are becoming an increasing segment of the ATRS portfolio and, currently, ATRS does not have procedures in place to obtain or monitor the market values of these instruments and consequently cannot monitor related investment returns.’ The ‘alternative investments’ described in this prophetic warning included many derivatives. Deloitte & Touche recommended that Arkansas ‘develop procedures to ensure that market values are periodically determined for their investments and that these market values are supported by verifiable data.’ A 2000 audit made similar recommendations.

“ATRS officials clearly did not understand the derivatives they were trading, and ATRS became the only state pension system in the U.S. to lose money in the offshore limited partnerships at the center of the Enron bankruptcy. As of mid-2001, more than 5 percent of ATRS’ investments were considered ‘alternative’ – a high proportion.

“In 1995 the Wisconsin Investment Board, which oversees the state’s investment fund, lost more than $95 million through positions in leveraged derivative instruments linked to Mexican interest rates and currency. When the Mexican peso plummeted in value in 1994, the Investment Board incurred $35 million in losses. That same year, Independence Township in Michigan lost $2 million through its misuse of domestic swaps.

“Legislatures in two midwestern states responded to these government failures. Wisconsin has become one of three states (along with Kansas and Missouri) that restrict derivatives holdings by government units, prohibiting the instruments except when used ‘for the purpose of reducing risk of price changes or of interest rate or currency exchange rate fluctuations with respect to investments held’ by the Investment Board. The state of Michigan, meanwhile, passed a law requiring government derivatives to be reported in audits, subject to the Michigan Freedom of Information Act.”

“But politicians usually have been far more interested in passing laws that regulate corporate use of derivatives than in examining governmental use. Forty states have legal definitions or other acts regulating the percentage of portfolios that insurance companies and other firms may invest in derivatives, while only Michigan has mandated transparency for government units dealing in them.”

It’s obvious the government is trying to play a game it doesn’t really understand. And it wants to do so with no accountability.

Frankly, it’s not surprising the government doesn’t want to police itself. It never has. Government has always thought it was above the law. But when it comes to the extreme risk associated with derivatives, the government is at particularly high risk – even more so than most corporations. At least corporations know they’re playing with their own money at their own risk. The government is playing with other people’s money. And no regulations means no accountability and no reason to care if they’re successful or not.

I mentioned earlier that JP Morgan is the bank with the largest holdings of derivatives. I also mentioned that if JP Morgan gets caught in an Enron-type fiasco, it could take down the entire banking industry – and the U.S. economy. As the top dog, what happens to J.P. Morgan happens to all the banks.

The risk for J.P. Morgan is huge – and it’s very real. No entity is too big to fail. This includes the U.S. government. If it is has a derivatives accident, the economic repercussions would be worse than the Great Depression, Hurricane Katrina, and 9/11 all combined. It would dwarf any problem that J.P. Morgan could ever produce.

Why would it be so devastating? Because of the interconnected financial system we live under right now. If the U.S. government is taken out financially, every country on earth would be devastated. Even countries that hate the U.S., such as Iran, would implode financially. Iran and most countries are so dependent on the U.S. for exports (such as oil) that any tangible slow down in exports will wipe them out financially. And if the U.S. can’t pay for its imports, a slow down – if not a complete stoppage – would definitely follow.

IV. Derivatives Are Easier Than Ever to Play

The fact that the government is involved in derivatives is clear evidence that you don’t have to be a genius to figure out how to get in the game. Even though derivatives are very complex, they are getting easier and easier to get involved in. The average investor can invest in options and futures without any trouble thanks to online brokerages and trading houses.

And just as many investors have lost their life’s savings in options, so can any government or business.

The number of derivative products on the market is growing daily. And not every firm that buys and sells them is located in an area where standards are high and there’s at least some oversight or accountability. With more people and institutions getting involved, these extremely risky companies will find their victims.

Even Alan Greenspan admits there could be trouble. He said, “The rapid proliferation of derivatives products inevitably means that some will not have been adequately tested by market stress.” So anyone getting into derivatives, as the government has done, “must be aware of the risk-management challenges associated with the use of derivatives,” added Greenspan, “and they must take steps to ensure that those challenges are addressed.”

The problem is that the derivatives market is so large and out of control that it’s almost impossible to take enough steps to address the challenges. No matter how careful an institution is it can still make a mistake. And one little mistake could bring down the entire system.

Conclusion

The likelihood of a derivatives meltdown isn’t a question of if, but when and how large. We’ve already seen several fatal errors. Those took down huge companies and robbed thousands of people of their life savings. We’ve also seen several errors that were nearly fatal to the U.S. economic system. Is it really unlikely we’ll see one that actually does cause a serious fallout? Like I said, it’s a matter of when.

The questions for you, then, is what can you do to protect yourself? What will hedge the derivatives meltdown? There’s only one answer to those questions – hard assets, such as precious metals and gems. But the best will be gold and silver.

Every other investment, including real estate, is connected to our country’s fiat money system. Most land and homes are mortgaged. And if they’re not, they still have to pay property taxes. A derivatives meltdown may not cause you to lose your home if you own it outright. But the value of it will drop like a rock. You’ll lose a substantial portion of your investment.

Stocks, bonds, mutual funds, currencies, and any other investment tied to the financial system will lose value overnight. Not only will millions of people be wiped out financially, but businesses, governments, even entire nations could lose everything.

The only investment that can possibly maintain its value and even increase in value is gold and silver. It’s not tied to the financial system in any way. Yes, it’s denominated in dollars today. But if dollars went away, you’d still be able to buy anything you need with gold and silver. For this reason, it’s good to have some junk silver on hand.

What if a derivatives accident isn’t big enough to wipe everything out, but still causes significant damage. This is very possibly – if not likely. In this situation, gold will still be your best bet. You may not lose everything else. But you can be sure the stock market would drop hard, causing most people to lose huge sums of money.

The fiat money system has created liquidity like we’ve never seen before. The number of players is growing daily. And the risk is growing exponentially every day. The more the world becomes leveraged on the derivatives market, the more risk we all sustain. It’s vital you’re prepared when it happens.

 

[Godwynn]

Just a quick question. Can't a lot of commodity meltdowns be attributed to individuals trying to corner the market on margin?

 

[Mise]

I didn't even know what the derivatives market was ten minutes ago.

To people who did, what do you think of this article, should we be legitimately worried?

I'll be honest, I couldn't be bothered to read the whole article. But the BBC's Business editor Robert Peston wrote about this subject in his blog this morning. It's a good read.